Pottering About
Last August my sub-heading for this introduction suggested some grounds for optimism with a final caveat (Reasons to be Cheerful 1,2 and 2.5). I fear I may be about to repeat myself in sentiment, although the context is very different.
Last year, I was finding reasons for hoping that a runaway bull market might hold up a little longer. This year I am going to suggest that we might have seen the end of a serious (and to be honest, long overdue) pull back to reality.
So what are this summer’s reasons to be cheerful and what ought investor’s to be worried about?
Back to old fashioned valuation metrics?
In simple terms, in July the US stock market had its best month in around 2 years on the back of better than expected corporate earnings. Yes, you read that right, the market did well because companies made money more or less within the range of analysts’ expectations. That’s how it should be and is what I call ‘normality’!
This is the second month of 2022 when markets ended up ahead, the other being February. When comparing the current market conditions to the 2000-2002 downturn, I previously reported that there were 3 false dawns before complete capitulation. So it may be too early to be calling the bottom of the market. Let’s think it through…..
Things we know
As always, I will base my analysis on facts already available and then talk about the probability of good and bad outcomes over the near and medium term. In the long-term equity markets will rise – that is a certainty during periods of high inflation because nominal values of almost everything go up.
Here are some obvious ‘headwinds’ – things that might apply selling pressure to equities:
- Runaway inflation meaning that consumers, already overburdened with debt, spend only on essentials (that paradoxically is actually good for some types of businesses) and economic growth in real terms stalls, leading to stagflation (inflation and stagnation).
- An energy crisis in Europe and possibly (but less likely) in the USA, causing a serious slowdown in industrial production, social unrest and a diversion of political focus into fire-fighting.
- Fire-fighting in the literal sense, or more broadly the consequences of climate change (I am not commenting on the causes or duration, only the symptoms we see now) and how that impacts on economic stability
- Political unrest at raised levels – not just in Ukraine, but also in China/Taiwan and to some extent in Europe as public dissatisfaction grows.
- Rising interest rates resulting in debt defaults, bigger equity discounts (explained in past musings) and perhaps an asset class re-alignment into fixed income securities, plus very high debt servicing bills for governments.
- Component or supply chain shortages with multiple alleged causes.
On the ‘tailwind’ or helpful side of the analysis would be these factors:
- There are no signs of a sharp pick up in unemployment – in fact in many industries there are shortages of workers. That means workers will be able to secure decent pay rises and are less exposed to personal budgetary constraints from reduced spending pwer. That of course may be part of a feedback loop into inflation.
- The high levels of inflation arguably have only two primary causes – energy costs and rising interest rates, both of which are likely to top out at some stage causing a drop off in published inflation numbers and an easing of the financial pain for consumers.
- Many businesses are actually benefiting from inflation in terms of bottom line profits, for now at least. Energy companies, obviously, but I can detect and read about plenty of cases of ‘greedflation’, corporates raining prices because they think it is acceptable in a context of public acceptance of double digit inflation, even if their cost base is not rising. Banks are also restoring dividend payouts after being restricted during the pandemic.
- Covid-19 has not gone away, but the extent to which it interferes with economic activity, outside of China, is much reduced.
- Governments are pushing capital investment in things like infrastructure and ‘home grown’ production. Capital investment has been woefully inadequate in the short termist, directors’ bonuses-led profit maximization of the last few decades, so this might be a positive turning point.
- Possibly because of Covid-19, maybe because of the disreputable behaviour of global leaders everywhere, there is an insecurity in society that is arguably leading to old people accumulating assets in anticipation of hard times ahead and younger people adopting an ‘enjoy it while you can’ attitude. I propose this theory as an explanation for the obviously robust levels of consumer spending that I witness living in and visiting countries in Europe and from absorbing global social media. Consumerism is the cocaine of capitalism and I don’t see any trips to rehab in the immediate future.
So, what does that mean?
I would want to assess at least 2 contrasting scenarios. Please comment if you have other ideas! My simple optimist/pessimist alternatives are these:
- That the recent sell off has eliminated all the froth in the market, burst the bubble, or whatever analogy you prefer and equities are generally fair value and those companies that can pay growing dividends are an ideal purchase for inflation proofing our portfolios.
- That the market is clutching at straws and central banks are going to make the usual mistake of overdoing the interest rate medicine, triggering a long recession which has not really even started yet.
At a tangent, now rising interest rates are an actual ‘thing’, investors need to re-assess the previously dead in the water fixed income asset class. I will return to that topic soon. The way you assess that would vary according to your optimism/pessimism.
If the above were the only 2 options I thought most likely, I would personally invest on the basis of the first assumption but keep what I have left of my 3 year spending reserve uninvested (a good 2 plus years reserve is currently still there as we only went into the bear market in late 2021). That is a sort of default ‘hedging’ approach that I like.
In terms of asset allocation, currency strength favours the US market against the European for British investors as long as US interest rates are climbing more rapidly then those in the Eurozone. For UK investors, investing in the UK market has the attraction of no currency risk but perhaps relative underperformance in the short term until a competent government with a clear policy is recognized by overseas investors. European markets are undoubtedly cheap(ish) at the moment for Sterling investors.
A review check on your current asset allocation and the appropriateness of your fund selections would make sense at this time, which leads me neatly on to the next section.
Digging Deeper
Structured reviews matter
My long term observation of investors’ behaviour at times when they come to look over their portfolios is that they almost always compare the absolute performance numbers of one fund with another, often without access to information about holding periods, through no fault of their own. This leads to natural conclusions about what has been ‘good or bad’ and what profit taking opportunities might arise, or maybe even what funds ought to be got rid of as failures.
This is a certainly a better approach than doing nothing at all, because it is a form of review. However, if this crude process is repeated many times, a portfolio will very likely under perform an algorithmic multi asset offering like those in the Vanguard Life strategy range.
This is because it will become completely unbalanced and the careful diversification elements built in at outset will certainly be diluted or even lost altogether.
In my opinion, if you employ an IFA, the most useful thing they can do for you is impose proper discipline on portfolio reviews with data reports at regular intervals in a consistent format, accompanied by intelligent personalised observations about your portfolio and recommendations for keeping it in line with your objectives.
If you are now running your own portfolio, you really must have a structured review process.
You can design it how you like. Some tools are available free from the likes of Morningstar, if your dealing platform offers those, but you will need to know how to use them and also what extra data you could usefully collect and summarise, making comparisons from one review event to the next.
This month I am going to highlight the import elements of a proper review, likely conducted half-yearly or annually.
The elements
Asset mix
It is written in the academic literature about investment that asset allocation contributes much more to total returns than fund selection. My years of experience confirm this and I would widen the maxim to say that the right asset allocation is also what keeps volatility within the acceptable parameters for a given investor.
The asset mix of a portfolio therefore needs to be looked at on every review occasion. It should be compared with the original target, which should have been recorded.
Imagine this scenario:
An investor allocated 5% of a new fully diversified portfolio to emerging market equities and 10% to physical gold – the latter as a defensive backstop. Over 3 years with no reviews, the emerging market fund doubles in value and the whole portfolio increases by 50% . The gold holding stays at around the same value. Why bother with reviews, all is going very well!
Because, in percentage terms, the EM equities are now 6.7% (10/150) of the portfolio and the gold is EXACTLY THE SAME PERCENTAGE ie 6.7% (also 10/150).
As markets have obviously been flying, the investor might want a larger defensive hedge but has in fact got as much in a higher volatility fund as the diversifier, when they planned to have double as much of the cautious holding!
At regular reviews, action should be taken to re-align the asset mix by profit taking and maybe topping up defensive holdings, or even buying into weak performers if an inflection in market style preferences is anticipated. Alternatively, if there is a rational case, the target asset mix can be tweaked as a base for future reviews, but ONLY if there is strong intellectual basis for such a change.
Funds review
As funds will have been chosen with diversification in mind, it is self-evident that over a given period, they will NOT all perform the same. If they did, there is no diversification.
So what we need to do is compare funds relative to their peer group of other funds with similar objectives, owning securities of the same sort.
This should be done over at least 1 and 3 year reporting periods and possibly 5 years as well. Note that a very poor recent period with large losses will pull the 3 year numbers down as well, so you should always end up looking at a graph, which will clearly reveal a generally good fund falling off a cliff or a fund steadily declining as quite different animals.
I suggest using quartile rankings in such comparisons. Ideally we want to own funds that do well in their peer group, so above the median fund (ie first or second quartile). If you want to own the top fund all the time, you will be forever trading and probably lose a lot of money!
Where results look weak, eg 4th quartile results over all periods, investigation is required. A fund may have been positioning for a market cycle change that was later than the manager expected, but just happened, so the fund is beginning to accelerate away just now!
If selling a fund on performance grounds, the correct discipline is to buy a fund in the same sector that is in your judgement clearly better run for reasons you have researched and understood, not just one with better recent data! In my young and naïve days, I often sold so called ‘dog’ funds and switched into a ‘star’ performer just as the latter ran out of steam because the market cycle was moving on!
When reviewing fund performance, I recommend applying 2 human characteristics, patience and decisiveness together – they are not mutually exclusive!
Cash flow planning
If you are in a drawdown situation, taking cash regularly from the pot of funds, check out the available reserve, sell strong performers to take cash and top up reserves, or even inflate them if you think the market is ‘overcooked’.
If there is a reasonable rate of interest available on cash, compare other highly defensive assets and see if in fact they are not worth owning (given they will carry some risk) relative to the interest yield on deposits.
Other actions
I will not bore you with more detail, but you can usefully look at your longer term results in total (eg over 3, 5 or more years), adjusting for withdrawals of course, to see how you are doing relative to your main financial planning roadmap. If you maintain a regularly updated total portfolio valuation graph, that will assist.
As a portfolio valuation will be a ‘brought forward’ into most people’s year by year cash flow plan, you may well want to see how your past projections are comparing with current reality and make some updates.
I am happy to offer more tips to those readers who subscribe for personal contact and coaching and I do have some spreadsheet templates available to help out – the most complex of which is subject to a small recurring fee to cover the development (by a subscriber to this blog) and support costs.
Finally, I would repeat my ‘ad nauseam’ counsel to remember that data presented at one point in time can be wildly misleading if taken in isolation – always look back over a time period and see what happened and try and work out why it happened and how that feeds into where we are now!
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